Bank Capital: It’s All the Rage

For understandable reasons, capital is very important to a bank. The equity share of a bank's liability structure forms part of its funding base (the other segments are customer deposits and "wholesale" funds), but is unique in being is what is available to absorb losses on loan assets.

Bank Earnings—What to Watch: Analyst
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To remain a going concern, the equity buffer needs to exceed, by some comfortable margin, all loan losses suffered by a bank at any one time.

Of course equity has a cost.

It is the most expensive part of a bank's capital structure but, as pertinent to a bank's business model, the more there is of it, the less able a bank is to undertake its core objective of "maturity transformation": the act of taking short-dated deposits like funds in savings accounts and turning them into long-dated loans like mortgages.

The more of a bank's balance sheet is equity, the less room there is for deposits.

So what is the "right" level? It comes as a surprise to many people, but banks have been required to adhere to an international standard for a minimum level of capital only in the last 20 years.

The Basel Accord, now in its third sequel as "Basel III", dates from 1988 but was implemented from 1992.

Prior to that, there was no universal minimum amount for bank capital.

So what did banks do? Did they hold no capital, or the absolute minimum they thought they could get away? That question reminds me of an interesting experiment carried out in a town in Sweden some years back, concerning road safety.

The local council removed all road markings and, even more drastic, traffic lights.

What do you suppose happened? Perhaps surprisingly, there was a lower level of road deaths and fewer road accidents.

Forced to take more responsibility for their own safety, drivers and other road users conducted themselves with greater care, thereby generating a lower accident rate.

An interesting article in The Economist this week (page 81) illustrates this for banks as well.

It suggests that the Basel III risk-weighted Tier 1 equity ratio minimum of 7 percent equates to an equity-to-assets ratio of about 3.5 percent, which is "lower than banks themselves thought prudent in the years before Basel." The average level for U.K. banks in the 20-year period up to 1992 was, as the magazine article quotes, around 5 percent.

In other words, the implication here is that the practical impact of regulation has been to create a minimum that banks often drive down to, rather than a more conservative level that would be more or less sufficient for all banks under all conditions (a thankless calculation to make!).

There isn't really a conclusion to all this, except to say that a "one size fits all" is rarely a good rule to work to.

Different banks have different business models and one would hope, in an ideal world, that each bank made the right decision on what the "right" level of capital should be.

The experience of 2002-2008 might suggest otherwise, but sometimes when it comes to regulation less may well end up being more.

Professor Moorad Choudhry is Treasurer, Corporate Banking Division, Royal Bank of Scotland.

"The views expressed in this article are an expression of the author's personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this article and accepts no responsibility for any consequence of their use. This article does not constitute an offer or a solicitation of an offer with respect to any particular investment."